Do consumers really want credit card reform?

Federal Reserve Bank of Kansas City - Economic Review,  Third Quarter 1999  by Combs, Kathryn L,  Schreft, Stacey L

• E-mail
• Print
• Link

An example with broader repercussions involves an increase in interchange-fee rates to offset the costs of the APR cap. Higher interchange fees increase merchants' cost of selling to customers on credit. To the extent possible, merchants will pass the higher cost on to consumers through higher product prices. In this case, even non-cardholders will be worse off because of the restriction.

These three examples illustrate that consumers in general cannot be said to benefit when issuers can adjust the non-APR components of effective price to circumvent the rate cap. While some consumers might benefit, others are likely to be harmed by the resulting mix of effective-price components.

When issuers cannot circumvent the restriction

The second possible outcome arises when issuers cannot adjust the non-APR components of effective price to circumvent the rate cap. In this case, the rate cap lowers the effective price to consumers, who want to borrow more revolving credit as a result. Whether they succeed at doing so and whether they benefit depends on issuers' market power. In general, consumers do not benefit from the pricing restriction.

When issuers lack market power. Issuers without market power are already pricing competitively (making all loans for which the revenue per dollar lent is sufficient to cover the extra cost of making the loan). For such issuers, an APR cap is necessarily below the cost of providing additional credit, so customer demand for credit cards is too great from the issuers' perspective. The increase in the volume of credit demanded drives up the cost of providing the additional loans since issuers must pay higher interest rates to attract additional loanable funds and higher input prices to attract more labor, equipment, etc. But the extra revenue from making those additional loans is less than the extra cost. In the absence of adjustments in the other components of effective price, issuers prefer to ration credit than to make such costly loans. Rationing can be accomplished by issuers raising credit standards and denying credit to higher-risk borrowers. Consumers who continue to get the credit they demand benefit because they pay a lower effective price for it, while those denied credit necessarily are harmed. Or, issuers can instead ration credit by continuing to serve all existing customers but imposing tighter credit limits or increasing the required minimum monthly payment. In the most extreme case, where the rate cap is so low that issuers cannot break even serving the market segment, complete rationing occurs. The market for card credit shuts down, and all consumers are harmed.

The bottom line is that when issuers do not have market power, the benefit to consumers from getting credit at a lower APR may not exceed the cost of reduced availability. Thus, consumers cannot be said to benefit from an APR cap. And depending on the extent to which rationing occurs, they may all be hurt.

When issuers have market power. When issuers have market power, there are two possible outcomes, depending on how low the APR cap is set. In the first case, where the cap is sufficiently low, the result is exactly the same as when issuers lack market power: issuers ration credit and possibly cease operation altogether.